Slowly get rich with dividends: Living on dividends alone?

A few weeks ago, I attended the Morningstar Investment Conference and took in the insights and predictions of all kinds of mutual fund managers and financial experts. On the whole, these folks weren't too optimistic about earning exceptional returns on any kind of investment. Bonds and cash have paltry yields, and stocks aren't as cheap as they were a couple of years ago. I think the collective investment advice of the event could be summed up by a line from Tom Hancock of money-management firm GMO, who said, “The only thing I like about stocks is they're not bonds.”

During the opening session, Pimco co-chief investment officer and bond fund manager Bill Gross bemoaned the low rates on Treasuries. He also argued that investors shouldn't expect 10% returns from stocks. But at the end of his talk, Gross suggested investors look for a solid, inflation-beating return from companies that pay steady dividends — companies such as Coca-Cola, Proctor & Gamble, Johnson & Johnson, Southern Company, and Duke Energy. (Full disclosure: I own shares of Johnson & Johnson, and when children pass me in the street they scream, “Gross!”)

Bill Gross was singing a tune similar to what has been wafting from the pages my Rule Your Retirement newsletter over the past few months: Stocks are not priced for exceptional returns over the next decade, and in a sideways market, dividends play an even bigger role in your portfolio.

As I listened to Gross, I wondered what would happen at the extreme: What if stocks didn't gain a penny and all we received was dividends? I fired up Excel and found some fascinating figures.

Benefits of Stock Dividends

First off, let's recap the benefits of stock dividends.

Unlike the interest from bonds, dividends tend to grow over time, historically at a rate that exceeds inflation. For most investors, the smart strategy is to use those dividends to buy more shares of stock, so that they'll receive even more dividends, so they can buy even more stocks, and so on. In a previous post, I likened dividend-paying stocks to money-growing trees that produce a little more financial fruit each year. If you buy more trees with that cash crop, you reap even more fiscal flora. Given long enough time, you could have a whole greenhouse producing the green stuff.

To illustrate how this can pay off over the long term, let's move from stalks to stocks and assume you own 1,000 shares of a stock that trades for $100, for a total investment of $100,000. (Note that this is just a hypothetical illustration; very, very few people should have so much money in one stock; also, the same principles apply to a mutual fund that pays dividends, even if you invest just $100.) The stock has a 3% dividend yield, so over the past year you received $3 per share, or a total of $3,000 in dividends.

Unfortunately, the price of this stock doesn't move much over the next decade. In fact, it doesn't move at all. Here's what such an investment would look like after 10 and 20 years, if the dividend increases 6% a year but the stock price doesn't budge.

Now

After 10 Years

After 20 Years

Value of Investment

$100,000

$151,726

$319,120

Number of Shares Owned

1,000

1,517

3,191

Dividends Received During the Last Year

$3,000

$7,885

$28,943

Annualized Return

N/A

4.3%

6.0%

While ten or twenty years of no price movement in a stock is disappointing, all is not lost. By reinvesting the dividends, you still earned money, thanks to owning more shares that each pay higher dividends.

Slowly Get Rich with Dividends

Like all illustrations of compound interest — i.e., earning interest on interest, or, in this case, dividends on dividends — it's not something that will make you wealthy overnight — but it could help you get rich slowly. (Hey, that would be a great name for a website!). Also, like all illustrations of compounding growth, it looks better the more time you give it.

If you can stretch your investing horizon even further — or if you're trying to convince a young investor to get started early — 30 years of reinvested dividends, growing 6% a year, will turn that $100,000 starting sum into $1.2 million, for an 8.6% annualized gain.

Earning 4% or even 8% on your long-term money may not sound exciting to some people. But that's not tragic considering it's based on a dire scenario: a stock that doesn't increase in value for 10, 20, or 30 years. Of course, I hope that any stock or mutual fund you buy does increase in value. And when that happens, dividend reinvestment pays off even more, because you're accumulating more shares to benefit from that capital appreciation.

An Uncertain Future with Stock Investments

This article isn't intended to persuade you to buy stocks. Stocks are volatile and risky and often stinky and all that. I am not offering boilerplate legalese when I say that I'm not 100% confident stock investments will be worth more in 20 years than they are today.

At the Morningstar Investment Conference, BlackRock CEO Larry Fink said, “Anyone who plans to be around in 10 years should be in equities.” It's not hard to see his point when you look at the alternatives. On the other hand, if you read the aforementioned link to Doug Short's site, you won't feel so sanguine about stocks.

As for me, I continue to own stocks in all forms — index funds, some actively managed funds, a handful of individual companies — but I don't expect exceptional returns; I'm basing my retirement on my ability to save, not on the return I earn on the savings. And I expect that dividend reinvestment will be a large source of any returns I receive.

Several of us were just discussing this the other day at work 🙂 High dividend stocks are of interest to me, but owning individual stocks is not. What are some good funds that would reflect this strategy? Would the expense ratio wipe out the small gains from the dividends?

Good to know. One thing though, for a fund that specializes in dividends; the yield seems laughably low. Why is that? My _average_ yield on my personal account is around ~4.76% and that’s just me messing around in my “play” account.

I believe both of those funds emphasize dividend growth, not yield. I.e., companies that have a long history of increasing the dividends each year are emphasized over companies that pay a high yield today. (Sometimes these are the same companies, but sometimes they are not). Someone can correct me if I’m wrong.

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SB (One Cent At A Time)

8 years ago

Dividend paying stocks are attractive, no doubt, but we can not live on them alone. If biggest concern is the lack of diversity the second concern is, no matter what we think, dividends make a company weaker! High dividend erodes significant investment capital which could have been made to improve business and thus improving stock price. On the other hand, if we see the yield on our investments, savings account, money market or CD rates are abysmal these days. We can buy a lot of stocks which pay high dividend instead. I have some of them, ad getting overall 4-6%… Read more »

This exact strategy represents my financial thinking as I edge itor retirement. The only way to get 3 to 6% return is in dividend. Any growth of the stock is just icing on the cake!. And certainly, this approach, while there is always the risk that the stock proce will go down, offers better returns than a CD or money market account. If the stock price falls, and the reason is not due to fundamentals, there is opportunity to by more and lower the overall cost of your investment.

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Mike Piper

8 years ago

Is the message here that high-dividend stocks: A) Have higher expected total returns than other stocks, B) Have less volatile total returns than other stocks, or C) Other?

If it is A or B, is there any accompanying research showing that to be the case?

If it’s not A or B, what is C? Admittedly, I’m having a hard time coming up with anything very meaningful.

Actually, companies that pay dividends are usually stable, mature companies that are not in the growth stage. Look at the companies Robert mentioned in the article (Coca-Cola, Johnson & Johnson, etc.), these companies have been around a long time and are not trying to get bigger. They pay dividends because there is not a lot of movement in their stock price. They have plenty of equity to redistribute to shareholders in the form of dividends to make up for the lack of capital gain in the stock price.

That’s true now, but if the market continues to offer such low returns, more companies will probably start paying dividends to get their stocks moving, especially if they’re raising capital through stock sales. You have to look carefully at each company if you’re going to buy single-pick stocks (which of course I assume you do, since you’re paying attention – but for other readers with the same question.)

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STRONGside

8 years ago

I enjoy taking advantage of a few DRIP funds that I have money in. They have performed well for me in the past few years, even with the crazy market we have had. I also love the quote about relying on savings rather than rates of return to secure your retirement. As powerful as compounding interest and a rate of return is, it will get you nothing if you are unable to save a substantial portion of your income. I have a long time horizon before retirement (30+ years) so I know that I can be aggressive with my investment… Read more »

well it depends on the drip. I have about a dozen stocks. Depending on a lot of things, fees can range between ~$1 and $5 per purchase. They typically charge even more if you want to sell.

I’d estimate about $2 per stock. It doesn’t sound like a lot, but $2×12[stocks]x12[months] = $288 a year.

Something like sharebuilder is probably cheaper. They have “12 for $12”.

Also if you are in mutual/index funds instead then you only have one purchase. Places like vanguard don’t charge anything for those.

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Drizzt

8 years ago

I believe there is a sweet spot for dividend stocks. The very high yields are likely associated with high risk, but if you get them during a recession then its a once in a lifetime deal. At the height of the crisis we have some REITS that i owned yielding 15%-20% when they are 5-7% now. Above all else it is what you own that is important. Dividends are paid out of free cash flows and that is generated through a sturdy business. I am trying to build up my dividend portfolio. At 180k and at a yield of 6%… Read more »

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josh

8 years ago

Good points Mike. A) high dividend paying stocks are generally growth stocks and over the long run value stocks have outperformed growth stocks. You are also forced to realize gains on dividends when they are paid to a taxable account, unlike capital gains which you can realize when you choose them. This means not only would your portfolio be more risky because you only own the high dividend paying stocks instead of owning the entire universe of stocks but you would have every expectation of earning less and being taxed more. B) High dividend stocks are generally a little less… Read more »

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Alexandra

8 years ago

I just want to say how much I enjoy these posts from Robert. I feel like I actually learn from them, and they are a fresh breath of air compared to posts about saving pennies by not washing your hair, and worrying about spending ten dollars on a dress.

“I’m basing my retirement on my ability to save, not on the return I earn on the savings.”

I’ll echo this. This is what I come to this blog for. It’s a good post. Lot better than posts on how to can jelly.

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No Debt MBA

8 years ago

I’m also focusing on putting a lot away for retirement, not on how much I can earn. However, high dividend yield stocks will likely be a component of my portfolio when I retire.

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Epell

8 years ago

I am a 24 year old young man who is currently saving bit by bit for my first Roth IRA next year. I hope to do so every year from now. I have a question about investing. Is stock index funds worth it? It seems that 20 year annual return for SP300 index fund is 4.1% per year adjusted for inflation (http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html) Average long term inflation rate is 3.24% (http://inflationdata.com/inflation/images/charts/Articles/Decade_inflation_chart.htm) so I’d think non-inflation adjusted yearly return is ~7.4%. That’s about the same rate of return Vanguard’s long term bond index offers. Past ten years, long term bond index doubled… Read more »

At 24, a stock index fund is a pretty good way to start. You’ll have plenty of time to adjust your strategy as you learn more. In my case, gains in stock prices had a notable effect in only two investments, out of more than two dozen stocks & funds I owned before rollover. The gains I had on individual stocks served mostly to offset the *losses* I had on other individual stocks! The overall growth of my account (to nearly $130K at age 45) is based on three factors: 1)continuous contributions 2)profit-sharing from employers 3)dividend reinvestment and splits Start… Read more »

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El Nerdo

8 years ago

Wow, thanks for this great post. I’ve been looking at dividend stocks in lieu of a savings account for my emergency fund. I have 2 questions that maybe someone can answer: 1) There’s a lot of buzz about dividend stocks recently. Wouldn’t a bubble on these stocks ruin the P/E ratio and therefore lower the rate of return on the investment? 2) For an emergency fund (let’s say between $1,000-$15,000), fees and commissions have the potential to eat into the returns, especially if you actually sell your stocks in an emergency. What is a good place to buy/sell stocks on… Read more »

Regarding the fees, I would look into mutual funds instead from Fidelity or Vanguard (or maybe a couple others). If you open an investment account with one of those companies, you can buy their funds without any fees at all.

Yes, MER and fees will seriously erode your returns if buying mutual funds. If you have a decent amount of money to invest, a better strategy is to simply look at the holdings of the mutual fund you’re considering, then buy those individual stocks. Find a mutual fund with the word “Dividend” in the name, and research its holdings (they’re required to make their holdings publicly available). Then just buy the top 10 stocks the fund holds, in the same proportions. Since high-dividend companies are typically mature, stable companies, there isn’t a lot of turnover in these mutual funds, so… Read more »

I’m not convinced that holding 10 stocks is suitably diversified, as sectoral imbalances/bubbles can lead to shocking results.

For example, the fall in BPs share price, or the fact that multiple British banks that constituted huge parts of the FTSE 100 have fallen from grace and have slashed/cut dividends in the last few years.

I’d go for the top 20, or 15 at a push if you did your research and were confident with all the companies involved.

My reasoning was that most of the mutual funds are heavily weighted toward 10 or so companies anyway. 10 companies might comprise 80% of the mutual fund’s holdings (by value), with the remaining 20% being a mix of other companies (in smaller portions), cash, and whatever else. Thus, if you just bought the top 10 companies in a Dividend fund, you’d fairly closely track that mutual fund, without paying the prohibitive MER.

Mr. Brokamp should probably answer that question, but … in my observation (of at least three investment “bubbles” over my adult lifetime), bubbles are based on emotionally-inflated demand for investments that have no proven value or whose valuation is completely dependent on demand (a self-reinforcing loop), like housing. It’s possible dividend stock prices could be driven up by demand, but – again, in my observation, and I am not a market expert – stable dividend-paying stocks tend to be pretty high-priced. Bubbles almost always start with something that has a low intrinsic value or a perception-based value. The value of… Read more »

Thanks guys for your answers. No, I don’t have a large amount to invest, this is more of finding a place for my emergency fund instead of a savings account, but it looks like this is not convenient until I reach a certain amount. Good to know, I wouldn’t want to get mired on e-trade not knowing what I’m doing, even if it’s just to buy some shares of Coca-Cola (I like them, they are a rock solid company and truly global, even if I don’t like soft drinks). I’ll stick to the bank until I have sufficient money to… Read more »

I am not sure why no one has mentioned it, but stocks is not a good place for an emergency fund. Stocks are too volatile and it will be your luck to need to tap into that e-fund when the stock values have fallen, thereby reducing the amount of money available for your emergency.

Not sure if it’s too late to reply, but this came up the other day in the “picking a new bank” thread; with the low interest rates on savings accounts somebody mentioned you were better off buying dividend stocks. It made me think, and I somehow trust the stability of the Coca-Cola company more than that of my local bank or the value of the US dollar– they are a truly global company after all: one market goes down, another goes up, they are *everywhere*. I can’t think of a safer place to put my money, but maybe I’m wrong.

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Xman

8 years ago

” Stocks are not priced for exceptional returns over the next decade, and in a sideways market, dividends play an even bigger role in your portfolio.”

I don’t think that is the case. i got into the market november ’10 and am up 130%. If you’re looking at large cap stocks, yes they will probalby go sideways but the smallcaps is whre it’s at.

small caps is where it’s at …. now. If you just got into the market, you will find over the years that the best performing stocks by class alternate. In a few years, large cap might perform better than small cap and foreign stock might perform better after that while small cap takes a third or fourth row seat.

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Jackowick

8 years ago

To address a few comments at once: *ANY* dividend could be said to be “cutting” potential capital investment for a company, but part of the valuation of the company itself comes from the fact the stock maintains a basic price based on the value of the dividend and… if this sounds like cyclical and cryptic logic, try to calculate your own P/E ratios using the last annual report. This stuff isn’t rocket science, but it’s how the market prices stocks in the first place. There’s a reason why different stocks are classified and valued in different ways (i.e. GOOG is… Read more »

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Jacob

8 years ago

I liked this article a lot and I’ve always been focused on dividends. One thing that I think is important to point out is that dividends, just like any other investment, are not guaranteed. Even companies that have grown their dividend over many years are often forced to slash it at some point. Think GE two years ago.

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Kevin

8 years ago

@SB: “High dividend erodes significant investment capital which could have been made to improve business and thus improving stock price.” With all due respect, so what? A higher stock price does nothing for the company. After the IPO, the stock price is meaningless. The price one private investor pays another private invester for n shares of the company is completely irrelevant to the company itself. Not all companies have opportunity for growth, and thus reinvestment is pointless. Take Coca-Cola, for example. It’s already in every market, everywhere, all over the world. There’s nowhere left for it to grow. But as… Read more »

Well and in many companies, bonuses and pay for the highest level of executives is based on stock price.

Not necessarily directly spelled out like that, but they are given chunks of stock for performance. Once your window for selling comes along, you certainly would like the share price to be higher — it makes your bonus bigger.

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Laura in Cancun

8 years ago

“fiscal flora” 🙂

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Leonard Waks

8 years ago

There appears to me to be a serious logic problem in this article. A company can not both be stable in earnings over 20 years and raise its dividend 6% — or any percent. Local and regional utility stocks pay a steady and reasonably high dividend because they have stable earnings. Their share prices have a lower beta. The P/E stays pretty stable. They pay out a stable dividend, but dividend growth is small to non-existent. A global powerhouse like JNJ or Coca Cola is constantly in search of growth. They pay a relatively low dividend but experience dividend growth… Read more »

I am a full fledged dividend growth investor, so I am excited you wrote about this. I only wish you had talked about yield on cost…maybe a future post. I usually start with the dividend aristocrats and screen from there. I’m planning to get my portfolio up to about 9% yield on cost by the time I retire, by investing in the types of stocks you mention – I hold JNJ, KO & PG. (I have a couple clients that have accomplished this so I know it can be done.) Any increase in stock price is gravy as far as… Read more »

Yield shown in stock quotes is the dividend as a percentage of the current price. If a stock is paying $3/year, but costs $100, the yield is 3%.

Yield on cost is the dividend as a percentage of what you originally paid. If I paid $50 for the same stock in the example, my yield on cost is 6% ($3/$50).

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Deserat

8 years ago

I believe that dividend yielding stocks/mutual funds can be part of one’s asset allocation. I look at it as streams of income – some are from dividends, some from interest, some from pensions, some from other assets,etc. Figure out what your lifestyle costs are and then configure the income streams to cover those costs. Those income streams may change over time in their proportions, due to either pensions starting/ending, asset ages, your age and income requirements, etc. In any case, it affords you also a diversified income stream.

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Bryan

8 years ago

There is a big assumption here that I have a hard time buying….

That dividends will increase 6% per year, starting at 3%. The 3% is reasonable, but the 6% growth in the dividend yield per year (especially on a flatlined stock) is hugely optimistic. At time 20 years, the dividend yield is nearly 10%.. The only time the average S&P dividend yield hit 10% was in 1932…and that was because the market had dropped precipitously.

I was thinking the same thing about the 6% increase in dividends. I think the inconsistency is that the dividend increases every year, but the stock price doesn’t. In reality as the dividend increases, the stock price will typically increase as well. Thus the stock’s yield won’t actually get near 10%.

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brooklyn money

8 years ago

I thought dividends were taxed as ordinary income, but I guess they are not. I’ll have to look into that more. Because taxes play a big part in how good the return actually is.

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retirebyforty

8 years ago

Once my investment income > expense, then it’s time to retire! Dividend paying stocks is the way to go right now. If the interest rate goes up to 10%, then I’ll change my investment.

Who cares about yield on cost as long as the yield is enough to cover expense… You need to constantly evaluate your investment anyway.

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Krantcents

8 years ago

If I converted my investments into dividend stocks, I could easily live on that income. I am still interested in growth and I am willing to give up current income to achieve it.

Also, it makes it easier to sleep at night if one’s investment cash flow doesn’t depend on capital gains—especially when the market is DOWN. Living off dividends feels like plucking the fruits of the tree; living of capital gains feels like sawing off branches. (Yes, I’m aware that this analogy breaks down at some point.)

PS: Instead of dividends, another way of generating income would be in writing covered calls on a growth stock portfolio. This is a tax-hassle though.

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Luke

8 years ago

In the great hunt for income, I’m planning to switch roughly 20% of my money into social lending. I’ve been using a social lending platform in the UK for the last 3 years and personally have been very pleased with the results. My average lending rate has been ~9%, although this is lower as I have to pay 20% tax on it and it’s impossible to have 100% of your money invested 100% of the time (as repayments from borrowers have to be ‘recycled’ into new loans). Still, I must be looking at a consistent return of over 6% a… Read more »

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Sara

8 years ago

Thanks for the article. I started with my first DRIP 7 years ago (XOM) and just added JNJ last year. I’ve been hoping to retire somewhat early (like 55 or 60 instead of 65 or 70) and hope that the dividends can help bridge the gap before I start to draw from retirements accounts. It’s also a good compromise for us – my husband is a lot more conservative than I am in investing, so having a steady dividend makes him feel better about having money in the market.

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K.C.

8 years ago

Robert, your ine about relying on your ability to save versus return on savings has been my philosophy for the last thirty years. I totally avoided the stock market and built a retirement from compounded interest and a lot of savings. My wife and I retired in 2009 at age 56. We discovered long ago that the only thing we could really control was the amount of money we saved.

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Nicole

8 years ago

I like dividends! Even if I drip them most of the time… http://nicoleandmaggie.wordpress.com/2011/02/03/dripping/ I have a full mix of assets and am gradually converting most of my stocks to indexes (which drip a bit). But I do have one single company stock that brings a big smile to my face every quarter when that unexpected few hundred dollars shows up in savings. Even though the company has gone bankrupt before, I can’t give it up. Risky, I know. My father is very anti-dividend. I think he’s planning to live very frugally on social security and then give all his money… Read more »

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Julie @ The Family CEO

8 years ago

Such good info. I, too, was interested in the statement about relying primarily on your ability to save for retirement. I wonder…what are the implications of investing for dividends inside a retirement account like an IRA?

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Jim

8 years ago

What happens in 2013 when taxes go up?

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Sandy

8 years ago

Nice chart with the 10, 20 years out. Reinvesting dividends even in a stock that doesn’t move seems more palatable than owning these stocks this day and age that are all over the board monthly. I need stability or I cannot invest at all. Too heart wrenching.

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carl

7 years ago

Great Article. I think having a side income of this would be great and to continue to build

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Dan

6 years ago

The title of the article got me to read it, but I feel like I’ve been misled and wasted my time. The article doesn’t address the question at all, but is rather only about the benefits of dividend reinvesting. This is quite the opposite of the title, which implies that we would be living off the dividends and not reinvesting them. During my productive work years, I’ve always used automatic dividend reinvestment. Now that I’m considering retirement, I’m wondering if I should reallocate my portfolio to even more equities that have high dividend yields and if those will be enough… Read more »

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Dave

6 years ago

Living on dividends alone can be somewhat tricky, but there are ways do it. A nice and informative article. I really like the idea of living off of dividends. Here’s an example of dividend cumulation: http://high-interest-yield.com/

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Mary

6 years ago

Of the oft-quoted 10% historical stock market return, almost half came from dividends. If you are not looking for dividends, you are missing out on a good chunk of investment earnings. You can set up direct stock purchase plans and dividend reinvestment plans at Computershare or Shareowneronline. These transfer agencies allow you to buy stock directly from the companies themselves, paying very small transfer fees. I invest $700 monthly into 10 companies – at TD Ameritrade where I have my IRAs and an Individual trading account, the monthly commission costs would be $99.90, which is 14% of what I am… Read more »

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E

5 years ago

Ok, but you realize that if your dividend grows then the value of the stock price rises too. E.g. 100$ stock with 3% dividend today means 3$/year in income. Now you are saying what if that dividend grows 6%/year? That means 10 years later it is paying 5.37$/year and 20 years later it is paying 9.62$/year. The yield would be respectively 5.37% and 9.62%. Essentially what should happen in your scenario is that the stock price would continue to yield its appropriate 3%, so when it is paying 9.62$/year, the shares would trade around $320. If you assume no growth… Read more »

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Ashish Agrawal

4 years ago

Thanks for the wonderful insight. Pardon my ignorance but I am unable to understand how the number of shares went up from 1000 to 1517 in the table given above. Please explain.

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Hi! I’m J.D. Roth. I'm here to help you master your money — and your life.

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